When will the Bank of England hike?

Last week saw sterling endure a rollercoaster week, rallying to a high of $1.4050 on Thursday before tumbling back to a low of $1.3760 on Friday. Given the recent volatility in financial markets (including equities, rates and commodities) three cents in GBPUSD could easily be written off as ‘noise’, but the move coincided with a change in expectations for UK interest rates.

After a week where the dollar had gained almost 3% against sterling, the pound rallied 1.5% to a high of $1.4050 on Thursday following the Bank of England’s latest monetary policy meeting. As widely expected, the committee voted unanimously to keep the base rate unchanged at 0.50% and maintain the pace of asset purchases at a constant pace (UK Government bond purchases at £435bn and non-financial investment grade corporate bond purchases at £10bn).

However, there was a notable change in tone regarding the outlook for policy in the months ahead. The minutes from the meeting stated that the committee would need to tighten policy “earlier and by a somewhat greater degree over the forecast period” than it assumed in November if its forecasts are proved correct. Given the Bank’s track record when it comes to forecasting, that is a big ‘if’ but for now at least, it looks as if we won’t have to wait until August (the date the markets had previously penciled in) for a rate increase.

In fact, in the immediate aftermath of the decision, OIS futures were pricing in a 73% chance of a 0.25% hike in May 2018 (as opposed to a 48% chance prior to the publication of the minutes). Longer term, the market remains unconvinced that the MPC will be able to dramatically raise rates and it’s still 50/50 whether we’ll see a second hike during H2 2018.

Justification for the uncertain outlook was provided on Friday when Michel Barnier warned that a transition period following Britain’s departure from the European Union in March 2019 was “not a given” and could be revoked if the UK fails to comply with the EU’s demands. The fear is that if a transition period cannot be negotiated, British businesses will not have enough time to adjust and as a result, the negative impact on the UK economy will be greater. If these fears prove correct, the likelihood is that the Bank of England will be accommodating regarding monetary policy going forward with the possibility that the MPC might be forced to loosen policy in an extreme case. The futures market reduced the probability of a rate hike in May to 62% and scaled back expectations for additional tightening going forward.

The news had an immediate negative impact on the pound, which had already failed to sustain its post MPC gains above $1.40 and saw the pair retreat down to a low of $1.3765 before stabilizing and closing Friday’s session at 1.3808.

What does this mean for the outlook for sterling?

At this stage, we see no reason for changing our views that we set out at the beginning of the year. Even if the Bank of England feels the need to raise rates in May, we don’t envisage a dramatically more aggressive tightening cycle compared to what is currently priced in. We continue to expect Brexit negotiations to provide a bumpy path for sterling and see little prospect in David Davis being able to negotiate what the British public would perceive as a ‘good deal’ for the UK. That doesn’t have to be a major negative for sterling however as we still believe the UK economy can grow and prosper outside the European Union albeit with one or two potholes to circumnavigate along the way.

Our bearish view on GBPUSD has more to do with expectations for a stronger dollar as opposed to a bearish outlook on the pound. If the recent downturn in risk appetite continues, we expect the dollar to be one of the key beneficiaries as investors look towards the safe haven appeal of US Treasury Bonds – but that is a topic for another week!

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